Luck vs. Skill in Trading

This article written by Bruce Bower was originally published in the october 2014 issue of Traders' Magazine.

Bruce Bower manages a portfolio of emerging market equities at a hedge fund. He has a keen interest in markets, psychology and self-development, having trained as a hypnotherapist.

In the markets, luck and skill are difficult to untangle. A lot of price action is often noise, leading to semi-random returns over a lot of time frames. Our win rate with any investing strategy will never be 100 per cent, so we have to contend with the frustration of putting on positions and frequently losing money. Even the best traders will experience drawdowns. But that shouldn’t deter us from the pursuit of genuine skill and mastery. Hedge Fund trader Bruce Bower explains how to handle this; in addition, he will discuss the premier way to becoming consistently profitable – via focusing as much on understanding and improving the process instead of putting too much weight on single trades

Better Lucky than Good

How often have we heard this expression? In some ways, it’s quite funny: We assume that luck can’t be taught and skills can, so we’d prefer to have luck and learn the skill part later. We find it interesting in a trading context, because most would prefer to possess just true skill, or even better, skill and luck. In the markets, luck and skill are difficult to untangle. A lot of price action is often noise, leading to semi-random returns over a lot of time frames. Our win rate with any investing strategy will never be 100 per cent, so we have to contend with the frustration of putting on positions and frequently losing money. Emotionally, this can be a challenge, as even the best traders will experience drawdowns while at times, investing can seem like playing poker, where you are diligently adhering to a well-reasoned strategy only to experience the frustration of another player winning the pot by making a long shot bet. At times like that, even the best poker players have been heard to exclaim, “better lucky than good”. But that shouldn’t deter us from the pursuit of genuine skill and mastery.

Know Your Stats

Despite all of the talk about luck, we have to ask: How do you even measure skill and luck? What would you measure in order to evaluate it properly? The answer to these questions is relatively straightforward in a card game like blackjack, where the odds are fixed in advance and known. With those, you can evaluate the situation and make a very good estimate of your odds versus the probabilities that you’re getting. If the pot is giving better betting odds than the implied probabilities, then it’s a good bet and you should do it. For instance, if it’s a ten per cent chance of winning but the betting odds are 20-1, then it’s a great bet.

However, this is more about statistics than anything else. That bet will hit and win lots of money approximately one out of every ten times, more than compensating you for the risk taken. If you did it 10,000 times, you would come out as a huge overall winner. But on any particular bet, any old thing could happen. You could conceivably lose 15 times in a row and it wouldn’t be out of the ordinary.

With your trading and investing, how do you know what the probabilities are? You need to keep similar records and/ or undertake comprehensive historical research in order to know your own odds and probabilities. You have certain entry criteria for putting on positions – which setups work and how often? How much do you make versus how much do you lose? And what exit criteria work best for positions, and when? From this huge mass of data, you should be able to work out a few of the most important statistics, like what works, how much it makes when it works, and how frequently it works.

The point of gathering this data is to face what the data is telling you about your trading. Once you have all of the data accumulated, then you can start to draw conclusions about your aggregate results. While you may remember one particular trade that worked really well, once you see all of the data, you may conclude that that whole strategy doesn’t actually work well. Probabilities and statistics assert themselves over long periods of time and large quantities of data. Thus, you need large sample sizes and a host of data to figure out what works. The more data and time, then the more you can discount the role of luck and attribute results just to skill.